personal views of a former fed trader

The Money Still Flows

The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation. Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power – credit, wages, and wealth – all appear to easily support elevated inflation. These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate. The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked. This post reviews the strength of household purchasing power along the three sources and suggests a dovish Fed pivot is far away.

Credit

Bank lending remains robust with loan growth accelerating to historically high rates despite recent rate hikes. This suggests rising borrowing costs are not deterring borrowers, possibly because their inflation expectations are more influenced by recent inflation prints. Loan growth can potentially continue, as households have strong borrowing capacities given their historically high net worth and rising wages. Note that it is also possible that structural changes in the banking system post-GFC have made higher rates pro-cyclical in credit creation, as rate hikes widen interest margins and encourage lending. The ongoing surge in bank lending is particularly noteworthy because banks create money out of thin air when they make loans. This new money moves through the economy and is part of what makes continually rising prices possible.

Bank lending growth rate is at post GFC highs (ex pandemic surge)

Wages

Wage growth has been very strong and is likely to remain so amidst an apparent shortage of labor across a wide range of industries. The 5% overall wage growth rate is historically high and appears to be accelerating. Lower income workers, who tend to consume a higher share of their income, are receiving the highest increases. All major labor market indicators suggest continued labor strength, from multi-decade low unemployment rates to a record 2 job postings per unemployed worker. The labor shortage may in part be due to a shrinking work force, in which case the shortage would be structural and less sensitive to higher rates. This suggests an even more restrictive policy would be required to moderate wage increases.

Source: Atlanta Fed wage tracker

Wealth

Household net worth rose to a record $150t earlier in the year largely from asset inflation and is still notably above pre-pandemic levels after recent declines. Even the price of Bitcoin is twice its pre-pandemic levels (Dogecoin’s price is 30x higher). On the liability side, many households improved their net worth by refinancing their debt and locking in historically low interest rates. The Fed’s tightening stance has reduced asset prices, but the market is undoing the declines by pricing in a dovish Fed pivot and rekindling risk sentiment. A stubbornly high level of household wealth would make higher inflation affordable and a return to 2% inflation rate less likely.

It’s Not Enough

The market’s implied path of policy appears to misunderstand the Fed’s priorities. Over the past few weeks the market has more aggressively priced in rate cuts in early 2023 following a string of weak economic data. The Fed’s current priority is inflation, and then full employment. This means declining economic activity is a desired outcome of monetary policy and not a reason for a dovish pivot. Nominal spending fueled by wages, wealth, and credit continues to grow at an exceptional rate, suggesting that monetary policy may still be too accommodative. The market’s move to price in rate cuts is effectively easing financial conditions when the effects of tightening are just materializing. The Fed will have to strongly push against market pricing to retighten monetary policy.

Source: Bank of America Q2 Earnings Call

102 Comments

  1. George

    Hi Joseph,

    Amazing and concise argument as always. What do you think about the view that the markets are just looking forward in time, and reflecting what is going to happen to demand/inflation and thus the fed’s response? Is there a scenario where the three metrics above all start rolling over in 2h22 and we then see the market’s pricing realized? Where do you think that is wrong?

    Thanks as always for making this public.

    • Steve

      The markets can be wrong at times.

      • Anonymous

        The fed raises to whatever the two year treasury is according to Gundlach.

    • Andrew_S

      I think Joseph’s points are exactly that. The forward-looking markets have yet to price in what the Fed wants to accomplish. Stocks pumping going into FOMC thinking the Fed will make things better starting this week is an incorrect judgement call to Fed’s intentions.

      Also, it seems there’s not enough awareness of QT that is unfolding. If we get 0.75% rate hike this week. Then the QT this month and next would make up for the 0.25% and then some (in a relative sense). The Fed wants to lower demand and they will attempt to get us there via tight policy.

      • Fxpoet

        Except there’s really hasn’t been any QT yet. Just look at the balance sheet stats, $15 billion only in first two months

        • Julian

          Exactly. I think the markets were under pricing the liquidity draining effects of QT prior to June, but 2 months in, it’s now a case of “what QT?!”

          • Tony

            QT of $30B was pulled off in June. But not in July. They only rolled off about $15 billion this month. They failed.
            Remember QT only involves notes and bonds but not T Bills.

        • Steve

          They just let short dated roll off…I think that adds a layer of obsfuscation.

    • George Dagnino

      I do not understand why wages are not taken AFTER INFLATION. They are declining after inflation. People are making LESS money as reflected by the pessimism documented in consumers’ surveys.

  2. RF

    Bank loan growth is growing for two key reasons right now, at least as I understand it:

    1) institutional debt capital markets are open, but remain very risk averse. High yield and leverage loan volumes are way down in 2022 versus 2021 as spreads have blown out and investors shun lower rated deals. This has opened the door for bank lending as spreads on bank loans remain fairly low, making it an attractive market to tap relative to HY/Lev loans. Consequently, the rise in bank loans represents a shift in where credit volume is being issued as opposed to a sharp rise in overall / new credit.

    2) Inflation is driving working capital demands higher at existing borrowers, causing funded amounts under existing revolving credit lines to rise.

    • Anonymous

      Beige book also confirmed your argument here, credit market is weak so firms are tapping loans

    • Joseph Wang

      Good points!

      • Lucas Roberts

        Hi Joseph,

        Wanted to let you know; i think somebody hacked your Twitter. Looks like you haven’t used it much since 2014, now I just got a DM from your Twitter account asking if I want trading advice

  3. Jon

    Excellent analysis. Thank you. Will you put out more public content via audio/ video?

  4. Metin

    Hi Joseph,

    What do you think about the idea that basically the debt is so huge that it is required to have negative real interest rates to deflate it?

  5. Paras Bhargava

    Jeremy siegel, who seems to be more of a monetarist than i realized when he taught macro, seems to be saying that fwd looking inflation is actualy easing. Its not clear if your thoughts arw at odds.

  6. Bryan

    Hi Joseph, great article as usual. I heard you on OddLots earlier today talking about how the Treasury market may be the weak link in the chain of things that could break. If the Treasury market does break and yields spike, does the Fed have any tools they could use to fix it that wouldn’t be perceived by the market as being dovish/easing? Wouldn’t they go to QE and/or YCC, or is there something else that could fix a broken Treasury market?

  7. Anonymous

    Fed Guy for FOMC Chair!

  8. dean

    I read Luke Gromen’s newsletter and He believes the pivot will happen this August due to 1) fed wanting to use inflation to reduce federal debt, 2) the higher interest costs of our debt plus entitlements will be unsustainable, and 3) the political implications of a recession.

    Loved hearing your arguments, any reaction to Luke? Big thanks

    • Harry

      Not a chance. Fed would lose ALL credibility.

      • Arthur Burns

        Correct answer. The Fed will make mistakes, but they won’t repeat the mistakes of the 1970s.

        • Spencer Bradley Hall

          The Keynesian economists have achieved their objective, that there is no difference between money and liquid assets.

          The FED no longer has the “tools” to control N-gDp. The money supply can never be properly managed by any attempt to control the cost of credit. Interest is the price of credit. The price of money is the reciprocal of the price level.

          The effect of the FED’s operations on interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact.

          The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the payment’s system.

    • Spencer Bradley Hall

      There won’t be a pivot until November. Powell deemphasized the role of money in the economy. To coverup his ruse Powell has destroyed deposit classifications. Powell eliminated the 6 withdrawal restrictions on savings accounts, which isolated money intended for spending, from the money held as savings.

      If you wanted to get rid of inflation, you should stop expanding the money supply, indeed drain the money stock, and then gradually drive the banks out of the savings business (increasing velocity). The 1966 Interest Rate Adjustment Act is prima facie evidence.

      M1 peaked @137.2 on 1/1/1966 and didn’t exceed that # until 9/1/1967. Deposit rates of banks decreased from a high range of 5 1/2 to a low range of 4 % (albeit not enough). A recession, as Powell said, was avoided.

      • Spencer Bradley Hall

        The O/N RRP facility is primarily used by the nonbanks (draining the money stock). So, the FED’s operations are not transparent.
        https://www.financialresearch.gov/money-market-funds/us-mmfs-repos-with-the-federal-reserve/

        Effective June 15, 2022
        https://www.newyorkfed.org/markets/rrp_faq.html

        “An RRP is a liability on the Federal Reserve’s balance sheet, like reserves, currency in circulation and the Treasury’s General Account. When RRP transactions are settled, the New York Fed’s triparty agent transfers the cash proceeds received from RRP counterparties to the New York Fed. This movement of funds from the clearing bank to the New York Fed reduces bank reserve liabilities on the Federal Reserve’s balance sheet,”

        The FED’s economists are contradictory.
        Link: “Understanding Bank Deposit Growth during the COVID-19 Pandemic”
        https://www.federalreserve.gov/econres/notes/feds-notes/understanding-bank-deposit-growth-during-the-covid-19-pandemic-20220603.htm

        “On the other hand, the deposits may leave the banking system if the holder of the deposits exchanges them for a different bank liability, such as longer-term bank debt, or if the deposits are used either to buy shares in a money market mutual fund, which then uses those deposits to buy alternative bank liabilities or Treasury securities directly from the U.S. Treasury department, or to invest them in the Federal Reserve’s Overnight Reverse Repurchase (ON RRP) facility.”

        But the FED doesn’t separate and record bank vs. nonbank purchases from the FRB-NY’s trading desk. Thus, the money stock is greatly distorted.

  9. George Dagnino

    wages AFTER INFLATION have been declining for some time. Same for personal income…same for retail sales. Figures should be used after inflation with inflation running at 9%+.

  10. Ravi Shanker

    Bank Reserves=$3.2T , RRP= $2.5 T , total= $5.7 T
    When the Fed “raises rates” they simply pay a higher interest on the reserves and RRP. Nothing else.
    In 2021 the Fed earned $107 Bn , which it returned to the US Treasury as required by law.
    The Fed has an “accounts payable” liability item as net interest income accretes.
    At a 2% “rate” the Fed would be paying out about $114 Bn/yr, while receiving around $100 Bn in interest on its bonds. So a negative net interest income.
    At higher rates , say 4% the Fed would have a negative net interest income of over $120 Bn/yr. This would accrete to that “accounts payable to the US Treasury” as a negative number.
    The Fed will cease payments to the US Treasury until such time as enough positive net interest has accreted to turn that “accounts payable” number positive – which may take years.
    So – net net , these rate increases ( Bernanke style) result in the US Treasury (AKA “taxpayer”) receiving $100 Bn/yr less from the Fed , and the banks and money market funds receiving $100 Bn/yr more from the Fed . Thats at a 2% “rate”.
    It seems to me this can be simplified by removing the Fed in the middle and observing that whats going on is the US Treasury is effectively paying out $100 Bn/yr to the banks and money market funds.
    Does this smell like a closet stimmy , a targeted fiscal stimulus aimed at the banks ? or something like that? And why is this supposed to drive down inflation is beyond me.

    • Ravi Shanker

      Oh I forgot to add: On that “accounts payable to the Treasury” . That item lives on the liability side of the Fed balance sheet right? If that is a negative number , its a negative liability – so the Fed I believe has a fancy term for it – like “deferred asset”.
      See- a neagtive liability is kind of like an asset. So that was a smooth move.
      Now. Which entity is on the other side of that ? The US Treasury ( AKA taxpayer).
      If the Fed has transmuted its “accounts payable to the Treasury” into a deferred asset , one would think the Treasury should mirror that by calling their negative “receivable” – a deferred liability?
      So – if the Fed raises “rates” beyond 2% and keeps it above 2% for more than a year , we will have the taxpayers owing the Fed money ( in effect). because the Fed done gone and paid out all its income and then some to the banks.
      Nice!

    • Don

      How does the Fed’s MBS holdings figure into this thesis?

      • Ravi Shanker

        MBS is just another asset , earns an interest rate. I was not addressing the asset sales of the Fed. Certainly MBS , with their negative convexity, have a different impact on the markets if the Fed sells them , versus Treasuries.
        I was only addressing this “rate” increase that everyone is obsessed about.
        Does’nt in any way change my observations.
        Its not a “thesis” or a “theory”.
        I am simply laying out facts. facts that you can verify at various Fed websites.
        Is there something in my observations you find unreasonable?

    • Yuri

      and the banks and money market funds receiving $100 Bn/yr more from the Fed

      This I don’t understand.

      The FED rate increase will increase all rates in the financial system. So banks/funds will be paying more for credits/money (also companies)

      • Ravi Shanker

        What do you not understand?
        First ask yourself – How does the Fed “Raise Rates”?
        Think about it.
        You remarked that the Fed rate increase would do such and such. OK . How do they “raise rates”?

  11. BenW

    Very sound, well thought out reasoning, but I expect the Fed to completely ignore this statement:

    “The Fed will have to strongly push against market pricing to retighten monetary policy.”

    And fall back to a 75-basis point FFR increase. The FFR will end the year at most 3.25%. If it climbs above 3.25% by any material amount, short-dated bills & note’s yields will move higher in tandem. Unless I’m mistaken, there’s something like $5T in bills & notes maturing in the next 30 months. The cost to refinance this debt as it rolls over will put significant upward pressures on what will be $600B in total interest expense for FY22 as tax revenues continue to decline. The Treaury’s GA will be dry by later this year, forcing another increase in the debt limit. We’ll borrow $1.5T each year for the next several years, and this could worsen. We’ll be at lesat $35T in debt by the time Joe Biden leaves office.

    JPowell will do everything he can to NOT repeat The Great Recession in terms of housing and, or job losses. He’s hoping inflation corrects itself below 5% which he can live with by this time next year. The likely result of this is 30YFRM will ebb below 5% before the end of the year, and housing will take a modest 10% decline by early next spring. At that point, these two forces will collide & cause the housing market to do a 180%. 15-20% YOY price growth isn’t likely, but upwards of a 10% recovery by early 2024 is very likely. Real job losses causing probably aren’t in the cards until next year sometime. Whether it’s January or April is hard to say.

    JPowell’s great hope is that inflation burns itself out by early 2023, returning to something in the 4% or below range. Which it very well may do. However, the housing market is what matters. The Fed should have starting selling MBS outright, maybe $10B a month, to help push up mortgage rates and to sustain them for several years. Housing needs to drop by at least 25% while forces keep the 30YFRM above 5.5% long-term.

    Time will tell, but I fully expect JPowell to pivot by next March during his “pause” event late this year in December. He doesn’t have the stomach for a rise in unemployment above 4% from the current 3.6%. And neither does Congress.

    If things do get a little ugly, do rent & mortgage relief come back? That’s the MOST important question. If it does, then we’re doomed. I only hope China’s real estate market tips over and pulls us down as well. A lot of houses like mine increased 100% in value in four short years which IS UTTERLY INSANE and is only outdone by the fake wealth created by digital currencies.

    • Ravi Shanker

      I think US real estate is in general very cheap, maybe excluding places like NYC and SF.
      There are very few places in the civilized world where you can buy a nice 3 bedroom house near a major city ,on its own half-acre of land with easy access to shops , internet , electricity, water etc. for $500K.
      Asia in general is much more expensive like for like. Western Europe too. Australia. NZ too. japan- fuggetabouit!
      Most of those places a young couple , each making a starting wage , say $50k/yr with a small amount of savings cannot dream of buying a house. Unless it is inherited!
      The big difference is property taxes almost everywhere outside the US tend to be small. Very small , certainly not 3% of the house value. Schools are financed by the govt , not with property taxes.

    • Capitalist

      Sound Analysis. But why do you think inflation will go below 4% on its own? Did not Joseph’s article here argue otherwise? Commodity prices are coming down but wage growth is strong. Labor market is tight. Deglobalization is bringing manufacturing to US. Isnt 5%+ inflation entrenched? Another point is if JPow is happy with 5% inflation, will the rest of the world be ok with USD as the reserve currency?

  12. Ravi Shanker

    As for this Fed Funds rate. It is the rate at which banks lend reserves to each other on an overnight basis. At least thats what it used to be.
    Today the banks are swimming in reserves. And there are Zero reserve requirements in any event. So the banks have no reason to borrow or lend reserves. They dont play in the Fed Funds market.
    So who plays in the Fed Funds market?
    It appears that it is mainly US branches of foreign banks and the GSEs.
    These foreign banks earn interest on their reserves at the Fed.
    The GSEs do not earn interest on their reserves at the Fed.
    So the foreign banks borrow reserves from the GSEs , earn the IORB and pay the GSEs something a bit less than IORB. Its an arbitrage market.

    • Ravi Shanker

      In short , the Fed Funds rate is an irrelevant rate that applies to the Fed Funds market that is a tiny backwaters market that no one cares about.

      • BenW

        Tell that to those who lived through the 80’s with nearly 20% FFR which sets the prime lending rate. And, it affects the short-term treasury’s such as bills and 2-3 year notes to a lesser extent. It’s far from irrelevant but certainly not as important as the balance sheet which should be selling off MBS.

        • Ravi Shanker

          In Volker’s time the way the Fed did things was they set a FFR target. Then they would drain reserves from the banking system by selling securities. And keep doing it until the FFR rate got to the target.
          banks had a 10% reserve requirement. Total reserves were $25 Bn in 2007, and less in previous years. Banks starved of required reserves woule compete fiercely in the market to borrow reserves from other banks in order to be able to extend credit.

          None of that is true today. There are NO reserve requirements. Banks have $3,2 Trillion in reserves. And as I have tried to explain above – the Fed simply pays the banks more money when they raise “rates”. And it is hard to see how they get much beyond 2% for any sustained period .

  13. Ravi Shanker

    I have explained in some detail above why the Fed is going to have a hard time keeping “rates” at even 2% for more than a few months.
    the Fed has never run a negative net income in its history.
    Congress may wake up and ask what happened to that $100 Bn/yr they used to get from the Fed. And maybe ask what that negative number means in the Feds “accounts payable to the US Treasury” !!
    its going to get very uncomfortable.

    Its not a great surprise that the “rate” increases thus far have done nothing to slow credit creation or wage growth. Again – all the Fed does when it raises “rates” is pay the banks and money market funds More Money. That is not tightening anything.

    Its a Cargo Cult style tightening. has all the cosmetic appearance of an old fashioned tightening ( pre-2008). But is entirely different . Villagers sticking sticks in their hair ( to simulate radio antennae) and building a thatched hut to look like a control tower did not bring the airplanes back ! ( read the Richard Feynman essay on cargo Cults).

    • Ravi Shanker

      See , when Bernanke came up with this Cunning Plan back in 2008 , he was utterly convinced that inflation was not ever going to be an issue in his lifetime. For all the usual think-tankish reasons – globalization, technology, demographics etc. Moreover he was a scholar of the Great Depression and consumed with fears of deflation.
      So his Cunning Plan fails when confronted with inflation .

      • Spencer Bradley Hall

        Bernanke is an idiot. As an example, look what caused the fall in housing prices, the GFC. M1 NSA money stock peaked on 12/2004 @ 1467.7. It didn’t exceed that # until 4/2008 @ 1514.2.

        Dec. 2004’s money #s weren’t exceeded for 4 years. That is the most contractive money policy since the Great Depression

    • BenW

      And let’s not forget about the $80B a year in free money the Fed is doling out via the reverse repo that is just now starting to decline from its peak of $2.3T.

    • Anonymous

      The fed will fold like a cheap chair. It’s much more politicized that Joseph thinks.

      The democrats are already setting Jerome Powell up to be the scapegoat for causing a massive recession.

    • Chris

      Thank you for your many comments. I agree that Congress has enjoyed the extra $50bn to $90bn per year from the Fed to the Treasury because it helps them spend more. When that goes away and actually becomes a negative they will complain.

    • rsm

      《Villagers sticking sticks in their hair ( to simulate radio antennae) and building a thatched hut to look like a control tower did not bring the airplanes back ! 》

      Should they have been thinking, how can we start another world war?

      • Capitalist

        JPow was asked about negative net income of Fed in his congressional testimony. Fed would not take taxpayers money, instead create a “Deferred Liability” on their book.

  14. Ravi Shanker

    Oops I seem to have chilled this comment thtread a bit/ Please carry on debating if it will be 75 bp or 100 bp.

  15. Anonymous

    recent inital claims surges high

    how can you interpret this situation despite of labor supply deficit

  16. Anonymous

    Hello,

    lowering asset prices make for lower tax receits , with Governdebts this high they won’t be able to afford raising rates…

  17. Truls

    This makes perfect sense in theory, but I just don’t see the market handling much higher rates before something breaks.

  18. NoMo

    The Fed’s bet is that it can knock down inflation by destroying demand through a reverse wealth effect — scaring the markets without crashing the real economy. The problem is, the market’s seen this show before. And 90% of the new money is passive flow — which doesn’t scare easy (maybe not at all). The talking heads are all out there telling us this time is different. No way Powell is going down as just another Arthur Burns. But the market’s not impressed. Powell’s a political appointee in an election year, after all. Will he pivot (again)? The question is not whether, but when. And how much damage will he manage to do first? The real economy is in real recession, after all.

  19. Wayne

    The US 30-year treasury currently being priced lower than 1 year is probably a manifestation of the market situation you have described. This is creating havoc for life insurance companies.

  20. Al Cheech

    The 2 job postings per person can be misleading. In the old days, businesses had to pay up front for advertising job openings (classified ads) whereas today businesses pay when a match is made online. Businesses keep them up as they don’t pay.

    As others posted, Fed hasn’t done any QT in two months.

    This Fed can’t raise rates as easily as Volker did because of the massive debt obligations (30T government debt plus trillions more in entitlements).

  21. Richard Pommier

    Hi. Thank you for great article. Then. I am struggling with the following. Real rates remain close to at their high of 2022. Isn’t it what really matters to impact economy ? Does the FED target and control those rates ? If this is the case how could nominal rates go lower when BE and FWD are already on targets ? Curious and puzzled. Regards

  22. Anonymous

    Not a single person on here mentioned something that is very very obvious… earnings growth is slowing significantly and will be negative by Q4 2022 of Q1 2023 at the latest. Couple slowing earnings growth with higher cost of financing and corporates are going to start laying people off almost independently of what the Fed does. The Fed is going to help this along, but will only be one part of the puzzle. One has to ask why do we debate Fed action anyway? To be policy wonks or to make money in markets? If its the latter, let’s focus on a few things. 1) a profit recession is bad for cyclicals and good for defensives. 2) PMIs sub 50 and negative LEIs, despite what inflation and the Fed is doing, always leads to lower back end yields. This was true in the 1970s when inflation was 11% and in the 1980s when inflation was 8%. So right now you want to be long duration and long defensives. If you can play the curve, play more inversion. Could rates go higher in the? Sure. But likely any spike in yields at the long end will be temporary as growth concerns cause a flight to safety.

    • Ravi Shanker

      In the 1980s – the Fed tightening had teeth. Volker raise the FFR to what around 20% ? And those days that meant he drained reserves severely from the banking system- causing a credit contraction. ( we had a Reserve Requirement then).
      Iam not at all sure the “Tools” we have today can ccomplish that. Paying the banks More Money is not the same thing as draining reserves to force the FFR up.
      The Fed , in any event, has no control over oil prices – caused by a decade of severe underinvestment and ESG. Or supply chain disruptions in China . Or the Russia war. So it seems likely that inflation will stay high.
      In any event the 1970s were brutal to long duration bonds. ( They were known as certificates of confication). What did well in the 1970s was energy stocks.
      Industrial cyclicals and mining may suffer due to higher input costs and demand declines.

      • Spencer Bradley Hall

        Volcker’s reign was a myth. Monetarism involves controlling total reserves, not non-borrowed reserves as Paul Volcker found out. Volcker targeted non-borrowed reserves (@$18.174b 4/1/1980) when total reserves were (@$44.88b).

        Monetary policy should delimit all required reserves to balances in their District Reserve bank (IBDDs, like the ECB), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman advocated, December 16, 1959).

        Volcker stopped inflation when he imposed reserve requirements against Now accounts in April 1981.

  23. DarthTrader

    https://www.federalreserve.gov/releases/h8/current/

    If you read the details over half (50%+) of the new credit went to consumers spending on credit cards. That should tell you EVERYTHING we need to know about how bad this is.

  24. Anonymous

    Article focuses on demand side of inflation and the scary implications that demand will remain robust. The current inflationary environment is far less demand side influenced but rather supply side. That we have healthy demand is a good thing, not bad, once supply improves.

  25. Howard

    I heard Ed Hyman today commenting that M2 is decreasing. Is it a concern that it is decreasing but from a very high level? What is more significant: the high level or the decrease?

  26. Ravi Shanker

    M2 is just the aggregate deposits at banks ( loosely speaking).
    Is there some link between M2 and GDP growth or inflation? Its not obvious at all.
    Think about what happened during QE:
    The Fed buys Treasuries . From whom?
    Lets say a pension fund wants to sell $1 million Treasury bonds . It sells them to a bank ( pensions funds cannot deal directly with the Fed).
    So the bank buys the Treasuries. How does it pay for it ? By creating a matching $1 million deposit in favor of the pension fund.
    Then a few minutes later the Fed buys the Treasuries from the bank, and pays for it with “reserves” ( deposits at the Fed).
    Sp M2 went up by $1 million. So what? All that happened is the pension fund now has $1 million in cash that it then invests in junk bonds or stocks or something.
    Maybe there is some vague linkage – that this akes the stock market go up, makes the general population feel more wealthy and therefore more likely to go buy an iphone. maybe.
    ‘Velocity” is a similarly murky ( nonsensical) concept: MV=GDP assumes there is some causal link between M ( M2 or similar) and GDP. And the velocity V is a number thats plugged in to make the arithmetic work out.
    Maybe we should create Cowlocity (C) : postulate that there is a link between GDP and the cattle population of Bhutan(B). Then we could say BC=GDP and easily calculate C.
    And thereby cement that Econ PhD.
    hey its a psudoscience – anything goes.

    • Randall

      Regarding QE, let’s say a bank has 1M cash to spare:

      It buys 1M of freshly minted bonds from Treasury.

      The government spends the 1M on government stuff, which creates demand for all sorts of goods and services and ends up back in deposits at the bank.

      The bank also sells the 1M of bonds to the Fed and receives 1M of freshly printed money.

      The bank now has 2M cash to spare.

      It buys 2M of freshly minted bonds from Treasury.

      The government spends the 2M on government stuff, which creates more demand for all sorts of goods and services and ends up back in deposits at the bank.

      The bank also sells the 2M of bonds to the Fed and receives 2M of freshly printed money.

      The bank now has 4M cash to spare and the government has spent 3M on government stuff, creating 3M of demand for goods and services using money printed out of thin air.

      Wash, rinse and repeat and pretty soon you have so much cash sloshing around in the system that the Fed has to mop it all up through reverse repos, which now stand at around 2.5T. This money is not neutralized or destroyed, it is just sitting quietly waiting for the right moment to come out and play. You have also created significant demand for goods and services, which you would expect would have an impact on both GDP and inflation.

      • Ravi Shanker

        Iam sorry , but thats just not how banks work.
        Banks dont need to have “cash to spare” to buy securities or create new loans.
        When a bank buys Treasuries , it simply creates a matching deposit in favor of the US Treasury.
        Then when the bank sells the Treasuries to the Fed , it receives Reserves to replace the “treasuries” on the asset side of its balance sheet.

        You should draw a T account and think in terms of the balance sheets of the banks and the Fed.

        • Randall

          That was a simple illustration because money markets are complex and opaque. Like water, the money will find its way. Your focus seems to be on the individual point in time transactions, rather than the process.

          If the government’s budget deficit is funded by issuing bonds and those bonds are purchased by the Fed (through whatever channels) using freshly printed money, then the government’s debt is being monetized. That gives a short term boost to GDP, which is the objective, but it is also ultimately inflationary, subject to changes in the velocity of money. Are the 2.5T in reverse repos not a sign of surplus money building up in the system? And what will happen if the holders of all that money decide that holding cash is not such a good idea?

          • Ravi Shanker

            The reverse repos are there to allow money market funds to earn an interest rate close to the IORB that banks get paid. Most of the money in RRP is your and my money market funds.
            This is money that would normally be invested in 30 day T-Bills. The problem in 2020 was the T-Bills were close to zero and the Fed was worried that the money market funds would “break the buck”. Thats why they expanded the RRP program.

            10 years of QE did not cause high inflation. because the Fed was buying bonds off the pension funds , and the pension funds were redeploying into equities, private equity, hedge funds etc. Thats not inflationary.
            The inflation started when the Govt started issuing stimmy checks and expanding fiscal deficits to alarming levels in 2020.
            That coupled with idiotic energy policies , ESG etc is why we have the current situation.

          • Randall

            10 years of QE may not have caused much consumer price inflation initially, but it surely caused asset price inflation, which has resulted in unconscionable class and generational inequality.

            The stimmy checks and expanding fiscal deficits in 2020 that you refer to were essentially funded by QE, which is when QE started to spill over into consumer price inflation. Cantillon sensibly postulated that inflation appears first at the point where new money is injected into the system (in this case asset prices) and then gradually spreads throughout the system (to consumer prices).

            I couldn’t agree more regarding idiotic energy policies and ESG, but for which I very much doubt that GrandMaster Putin would have invaded The Ukraine.

          • Spencer Bradley Hall

            Jerome Powell doesn’t have a clue. He has destroyed deposit classifications and overstated deposit volumes.

            If banks were intermediaries, we wouldn’t have this problem.

    • Spencer Bradley Hall

      M2 is mud pie. Economists are plum dumb. The turnover ratio of DDs to savings accounts is 95:1.
      Link: The G.6 Debit and Demand Deposit Turnover Release
      https://fraser.stlouisfed.org/files/docs/releases/g6comm/g6_19961023.pdf

    • Spencer Bradley Hall

      No money stock figure standing along is adequate as a guidepost for money policy. And Vi has at times moved in a completely divergent path (opposite direction) from Vt., as in 1978, where all economist’s forecasts for inflation were drastically wrong.

      Money has no significant impact on prices unless it is being exchanged. To sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once, or $200 (Vt) twice, etc. Or a dollar bill which turns over 5 times can do the same “work” as one five-dollar bill that turns over only once.

      The real impact of monetary demand on the prices of goods and services requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Milton Friedman’s income velocity, Vi, is a contrived figure (Vi = Nominal GDP/M). It is a “residual calculation – not a real physical observable and measurable statistic.” The product of M*Vi is obviously N-gDp.

      AD = money times transactions’ velocity, not N-gDp as the Keynesian economists claim. “Money” = the measure of liquidity; the yardstick by which the liquidity of all other assets is measured. I.e., M2 is mud pie.

      Income velocity may be a “fudge factor,” but the transactions velocity of circulation is a tangible figure.

      I.e., income velocity, Vi, is endogenously derived and therefore contrived (N-gDp divided by M) whereas Vt, the transactions’ velocity of circulation, is an “independent” exogenous force acting on prices.

      • Ravi Shanker

        “money” ( ie. bank deposits) have grown dramatically due to QE. These deposits were created as banks bought Treasuries/MBS to then sell onwards to the Fed. Then these deposits moved around bidding up the prices of financial assets ( stocks etc).
        In the last year or so , a lot of these deposits have relocated to the Fed’s RRP ( with a corresponding decline in reserves) – to take advantage of the Fed’s generous interest rate on RRPs..
        Iam not sure I get the distinction you are making between Vi and Vt. Both seem contrived.
        First there is the assumption that there is some causal link between “money” and AD or GDP. Then you find the appropriate multiplier to create a nice neat equation.

        • Ravi Shanker

          The portion of “money” ( deposits) being used to buy wheat or oxen ( I know!) I would guess is miniscule. And yes one could, for amusement, find an appropriate multiplier on just that tiny bit of the money supply (if it were even possible to figure out what percent of the money is actually used by the peasants for wheat and such) – so the calculator produces the AD or GDP.

          • Spencer Bradley Hall

            The monetary base was required reserves. An increase in the currency component is contractionary.

            link: Bank Reserves and Loans: The Fed Is Pushing On A String” – Charles Hugh Smith
            http://www.elliottwaveanalytics.com/2015/05/bank-reserves-and-loans-the-fed-is-pushing-on-a-string/

            I predicted the 4th qtr. 2008 crash. I predicted the bottom in March 2009. I denigrated Nassim Nicholas Taleb’s “Black Swan” theory (unforeseeable event), 6 months in advance and within one day. I predicted both the flash crash in stocks on May 6, 2010 and the flash crash in bonds on October 15, 2015.

            The Stock Market Was Rocked by a Mysterious ‘Flash Crash’ Five Years Ago. What You Need to Know. | Barron’s

            “Diminishing market depth and a surge in volatility were both on display Oct. 15, when Treasuries experienced the biggest yield fluctuations in a quarter century in the absence of any concrete news. The swings were so unusual that officials from the New York Fed met the next day to try and figure out what actually happened”
            Link: “Diminished Liquidity in Treasury Market” or:
            https://acrossthecurve.com/?p=19499

            “(Bloomberg) — Trading Treasuries keeps getting tougher and tougher.
            For decades, the $12.5 trillion market for U.S. government debt was renowned for its “depth,” Wall Street’s way of talking about a market’s ability to handle large trades without big moves in prices. But lately, that resiliency has practically vanished — and that’s a big worry.”

        • Spencer Bradley Hall

          Economists are vacuous. 1978 is prima facie evidence. Remember that in 1978 (when Vi rose, but Vt fell) all economist’s forecasts for inflation were drastically wrong.

          Put into perspective: There were 27 price forecasts by individuals and 9 by econometric models for the year 1978 (Business Week). The lowest (Gary Schilling, White Weld), the highest, (Freund, NY, Stock Exch) and (Sprinkel, Harris Trust and Sav.).

          The range CPI, 4.9 – 6.5 percent. For the Econometric models, low (Wharton, U. of Penn) 5.7%; high, 6.6% U. of Ga.). For 1978 inflation based upon the CPI figure was 9.018% [and Leland Prichard, in his Money and Banking class, predicted 9%]. Pritchard also predicted that velocity had reached a permanent high in 1981 – because of the DIDMCA of March 31st 1980.

          The ratio of transaction deposit turnover to savings deposit turnover is 95:1 So M2 is useless.

  27. Tats

    Great post thank you. The first post of loan creation from banks reminds me of a recent Jeff Snider podcast I heard. I would love to hear your thoughts on his thesis and belief that central banks are unable to influence anything except with words and that the true driver of growth or inflation is the eurodollar system.

    • Spencer Bradley Hall

      Snider doesn’t know a credit from a debit. The E-$ market is contracting. The contraction of the E-$ market has been going on since 2007.

      It was accelerated by Basel III’s LCR, and Sheila Bair’s assessment fees on foreign deposits, which changed the landscape of FBO regulations. It helped make E-$ borrowing more expensive, less competitive with domestic banks (the exact opposite of the original impetus that made E-$ borrowing less expensive, when E-$ banks were not subject to interest rate ceilings, reserve requirements, or FDIC insurance premiums). And now Powell has eliminated required reserves.

      And the remuneration of interbank demand deposits acts as a foreign governor too.

      All prudential reserve banking systems have heretofore “come a cropper”. The E-$ market is following that historical precedent.

  28. Spencer Bradley Hall

    Jerome Powell has lost control. Bank Credit, All Commercial Banks (TOTBKCR) is on a tear.
    https://fred.stlouisfed.org/series/TOTBKCR

  29. rsm

    Someone said:

    《Cantillon sensibly postulated that inflation appears first at the point where new money is injected into the system (in this case asset prices) and then gradually spreads throughout the system (to consumer prices).》

    What if the Fed created individual CBDC deposit accounts that paid interest equal to inflation, and put a basic income in it each month?

    Since asset price inflation was good for QE recipients, why not make everyone rich so they spend money on asset prices which is good inflation for all participants?

  30. Ravi Shanker

    On June 15, 2022 the FFR was at 0.8% .
    The 10yr Treasury yield was at 3.5%

    Since then the Fed has “raised rates” by 150 bp .
    On July 28, 2022 the FFR was at 2.3%
    The 10yr Treasury yield was at 2.6%

    So I guess paying the banks more money and the moneymarket funds more money as interest ( AKA “raising rates”) has eased monetary conditions considerably.
    “raising rates” bernanke style is not a tightening at all.
    Its like saying you are going to punish your kid for bad behavior by buying him a tub of his favorite ice cream. “punishment” is not punishment. The words dont mean what they used to mean.
    Thats why the stock market is soaring, mortgage rates have sharply declined and inflation has not budged from its 9% level. And the kid continues to trash his room !

    • rsm

      《paying the banks more money and the moneymarket funds more money as interest ( AKA “raising rates”) has eased monetary conditions considerably.》

      So why couldn’t they pay individuals more money as interest on deposits?

      • Spencer Bradley Hall

        The recipe was the fallacious Gurley-Shaw thesis (that banks are intermediary financial institutions).

        “substitutability between money and wide range of financial assets, also called near- moneys”
        “an appropriate definition of money must include the liabilities of non-bank financial institutions.”

        Interest rates are determined by the supply and demand for credit. Remunerating interbank demand deposits creates an artificial supply of loan funds. And the monetization of debt takes demand off the markets. It reduces R *.

        High real and firmer rates of interest are created by putting savings back to work, completing the circuit income velocity of funds. This produces a higher level of noninflationary AD (as predicted in 1961).

        Banks don’t lend deposits. Deposits are the result of lending. All bank-held savings are frozen, lost to both consumption and investment (the deceleration in Vt is the cause of secular stagnation).

      • Ravi Shanker

        If you have a money market fund you are getting paid , by the Fed. Take a look at your money market funds holdings and see what perecent of the assets are in the Fed RRP .

        • rsm

          So why not have the Fed offer individual (CBDC) deposit accounts that pay interest higher than inflation, to encourage individual savings?

          • Ravi Shanker

            CBDC – yeah. You’ll have a debit card directly with the Fed. The govt will put in money and take out money as it sees fit. You will have a carbon score, a social credit score, your vax compliance score and chemical analysis of your toilet bowl.
            And all those score will be analyzed by a sophisticated AI program to determine what you can buy , when you can buy it, how far from your house you can drive, if your car will even start, what temperature you are allowed to keep your house at, how many hot showers you have ….. amnong other details.
            And god forbid you made a joke on a social media site or said anything vaguely critical of govt policies – your debit card will get frozen ( just like on Twitter) until the authorities think you have learned youtr lesson.
            If you are over 12 years old and a functioning adult – I assume you dont view that as a great benefit.

          • Ravi Shanker

            You’ll get periodic harsh alarms on your govt mandated cellphone – to go get your vax booster, shelter in place , eat less meat and other such things.
            You’ll have to have a govt mandated app on your cellphone that will track your movements – and you will periodically be pinged and have to respond immediately or a couple of guys dressed like space cowboys will haul you off to jail ( it already happened in Australia).
            All for your own benefit ofcourse.

          • Ravi Shanker

            And ofcourse, once CBDC is established all paper money, coins, and other types of credit cards, debits cards etc will be outlawed.
            There will be no- way-out.
            Maybe build a wooden raft and try to get to Guetamala. ( unfortunately every country other than ours has strict immigrations laws – so there is that).

          • rsm

            What if we design a CBDC that avoids all of the undemocratic control Ravi’s so frightened of?

  31. Ravi Shanker

    The Fed Funds Rate applies to the Fed Funds market. This market is $90 Bn . Tiny relative to the overall market for fixed income securities. A rounding error.
    The banks dont even play in the Fed Funds market. Why does any bank need to borrow reserves from another bank? There are Zero reserve requirement. And the banks have $3.2 Trillion of the stuff.
    The Fed Funds market today – who even plays in it? Just a few foreign banks that borrow reserves from the GSEs . Because the foreign banks are allowed to earn interest on their reserves while the GSEs are not.

    • Ravi Shanker

      Just to put that Fed funds market of $90 Bn in perspective, one bank JPM alone has over $1 Trillion in reserves.
      By the way the Fed is now paying JPM about $23+ Billion/yr on those reserves.
      Nice. I want that job!

      • Ravi Shanker

        Thats $23 Billion that would have gone to the US Treasury (AKA “taxpayer”) last year.
        So hope JPM sends us all a nice Christmas card.

  32. Ravi Shanker

    So if the Fed “raises rates” to say, 4% , all that means is they will be paying JPM $40 Bn/yr. Thats even nicer!
    But why will that reduce the price of eggs?

  33. anon

    Wages are rising but Real Personal Income ex Transfers are almost negative, what do you think about that?

    • Spencer Bradley Hall

      The American Bankers Association is responsible for secular stagnation. Lending by the Reserve and commercial banks is inflationary, whereas lending by the nonbanks is noninflationary. Rather than bottling up existing savings, the authorities should pursue every possible means for promoting the orderly and continuous flow of monetary savings into real investment, aka the “Taper Tantrum”.

  34. Ravi Shanker

    to “rsm”
    What excatly makes you so excited about CBDC?
    What problem does it solve?
    Our banks function quite well.
    Transferring money is no problem.
    We have debit cards and credit cards – paper money is hardly used.
    We are already in a “digital money” age. have been since the 1970s when credit cards took off.

    So please explain what you think CBDC brings to the game?

  35. Ravi Shanker

    You dont need CBDC in order to get “stimmy checks” from the govt. Stimmies went out just fine to people’s bank accounts in 2021.
    In fact this whole blockchain based “trustless” contracts etc seem quite impractical.
    In the real world contracts get broken. There are disputes.
    We have contract law. lawyers. Lawsuits are filed everyday and we have a system for resolving disputes in the courts.

    In a CBDC world – if you see a strange transaction, that you did not authorize, who are you going to call? What protections do you have?
    So you will have to reinvent an entire complex system that has functioned quite well for 50 years. For what additional benefit?

  36. "rsm"

    Ravi Shankar, has the banking system functioned well for me, though? Why should I have to deal with offensive people who don’t like my lifestyle anyway and don’t make enough off me to justify trying to please me?

    Weren’t stimmies delayed for several weeks or months after they were announced? Why did we get a paper letter telling us the stimmies were coming, instead of just the stimmy itself?

    《What protections do you have?》

    Does the Fed’s money printing power make protection easy? I.e when repo blew up in 2019 or when fraud threatened Mortgage Backed Securities in 2008, did
    the Fed turn on the money spigot to protect traders?

    《What problem does it solve?》

    Why should I have to deal with private banks? Why shouldn’t Uncle Sam provide for me from the same limitless supply it uses to provide for bankers?

    • Ravi Shanker

      You are either very young – in which case i would say – forget this stuff and enjoy yourself.
      Or you are a troll or a bot trying to bait . In which case you have failed.
      This thread has been extremely disappointing and disconcerting.
      i hope its mostly trolls . that would make me feel better about the state of our culture.

  37. Ravi Shanker

    CBDC will turn all regular folks into eunuchs ( Google it)
    Its not gonna fly.
    The Chinese Communist Party would like some round eyed barbarian eunuchs to wear dresses and dance for the Royal Court.
    It Aint Gonna Happen.

    • Ravi Shanker

      The CCP needs to spend its precious bodily fluids worrying about its own future.
      I give it 24 months(max) – before the Chinese are freed from their CCP nightmare.

      • Ravi Shanker

        Tighten your belt and Hit the Road. (Belt & Road) – and may the wind behind your back not be your own !!

  38. rsm

    Does it say a lot about our friend Ravi, that he feels oh so trolled by anyone who points out that bankers are shallow, greedy, ignorant, flabby ppl who only survive due to unlimited public money-printing?

  39. k.n

    Joseph, I work at a $2b hedge fund. We would love to talk to you about the Fed ‘s mechanics and have some questions about who buys treasuries. Would you be willing to speak? Happy to pay a fee to speak w/ you.
    Thanks.

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